Even in this environment, you can harvest attractive income while controlling investment risk. By Eleanor Laise, Senior Editor September 1, 2012 EDITOR'S NOTE: This article was originally published in the September 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.Feeling parched? Income-focused investors are suffering a long drought as Treasury yields scrape along near historic lows and money-market funds and other conservative holdings pay next to nothing. And there's little relief in sight. The Federal Reserve announced in August that economic conditions would likely warrant "exceptionally low levels" for interest rates at least through late 2014. SEE ALSO: Special Report on Maximizing Social Security Benefits Those conditions are driving many small investors to take on greater risk in a quest for yield. Investors in or near retirement, though, can't afford to follow the risk-taking crowd. Nor can they afford to hide out in Treasury bonds, which are likely to deliver negative returns after factoring in inflation. They can, however, find steady investments yielding substantially more than Treasuries that help them stay a step ahead of inflation -- and sleep at night. The key is to build income portfolios block by block, keeping some assets in rock-solid, low-yielding investments to cover near-term expenses. Money that's not needed for several years can be stashed in slightly riskier, higher-yielding holdings. Advertisement Reining in performance expectations during this yield drought is also a healthy move for your retirement plan. If you don't, you might be tempted to load up on riskier stocks in a struggle to keep your portfolio in line with an unrealistic return target. Consider a retiree with a 60% stock, 40% bond portfolio who has mapped out a retirement draw-down strategy based on a 7% annual return assumption. If he can earn 5% annually on his bonds, he needs his stocks to deliver 8.3% annually to reach the 7% return target -- a bogey that the compounded returns of Standard & Poor's 500-stock index have hit in 75% of rolling 20-year periods since 1927, says Brent Burns, president of money-management firm Asset Dedication, in Mill Valley, Cal. But if he can only earn a more realistic 3% on his bonds, he'll need his stocks to deliver an annual 9.7% -- a target they've hit in only 65% of 20-year periods. As Burns puts it, "Yikes." Confronted with such stark numbers, Burns says, "the prudent answer is to save more and spend less." But you can also harvest attractive income and dividends while controlling investment risk. Here's how to keep the income stream flowing. Shop for cash deals. Some older investors are so disgusted with the dismal yields on savings accounts and certificates of deposit that they've taken a weed whacker to their cash holdings. Nik Dholakia and his wife will both turn 65 in the coming months and are on the brink of retirement. Yet because of the low rates on bank products, their cash allocation is "shockingly minimal," says the Narragansett, R.I., college professor. Instead, he holds a range of stock and bond mutual funds as well as individual stocks. While he's not sure how much his portfolio yields, he says, "I'm sure it does a lot better than those CDs." Advertisement For most retirees, this damn-the-torpedoes approach may cause high anxiety -- and possible disaster when confronted with unexpected expenses. The safer route: Keep at least a couple of years' worth of living expenses stashed in ultra-conservative holdings. That doesn't mean you have to accept the 0.03% yield paid by the average taxable money-market mutual fund. Bank accounts can offer better yields. While the average savings account tracked by MoneyRates.com paid 0.19% in the second quarter, the most generous of those accounts offered 0.85%. Shopping around "does make a difference," says Richard Barrington, senior financial analyst at MoneyRates.com. To find higher yields on savings accounts, consider online banks, which offered average rates of 0.58% in the second quarter, compared with 0.14% for traditional banks. And be careful to sidestep fees on checking accounts. With rates so low, those fees can easily exceed any interest you earn on a savings account, Barrington says. Many community banks, he says, offer free checking for customers over 50 years old. When shopping for CDs, don't ignore longer-term products just because you think there's a slight chance you might withdraw the money early. Penalties for early withdrawal tend to be relatively minor compared with the yield advantage gained with longer maturities, Barrington says. The highest-yielding five-year CD, for example, recently offered 1.85%, compared with 1.1% for the top one-year CD, according to Bankrate.com. Advertisement Although mutual fund firms have lately launched more ultra-short-bond funds aiming to lure investors seeking slightly higher yields on cash-like holdings, these funds don't have many advantages over bank products for retirees seeking safety. They lack the federal deposit insurance that comes with bank deposits, and they don't have the money-market mutual fund commitment to maintain a stable $1 share price. What's more, fund fees can sharply reduce investors' yield. The average ultra-short-bond fund charges an expense ratio of 0.7% and yields 1.2%, according to investment-research firm Morningstar. Simplify core bond holdings. Treasury bonds, a traditional pillar of retirement-income portfolios, have become a punching bag for advisers and analysts. Harvey Rowen, chief executive officer of Starmont Asset Management, in San Francisco, calls the ten-year Treasury "the most risky investment today." Indeed, with the ten-year Treasury yield this summer dipping below 1.4% -- and inflation at 1.7% in the year through June -- there's little for retirees to love in these bonds. Treasury inflation-protected securities, whose principal is adjusted in line with the consumer price index, aren't attractive either. In early August, TIPS with maturities of up to ten years offered negative yields. Retirees who want their bond income to help cover living expenses have other low-risk options. The Defined Income separate account managed by Asset Dedication (www.assetdedication.com) creates a tailored portfolio of CDs, government-agency bonds and other high-quality bonds that precisely matches the investor's income needs for a certain number of years. Advertisement The individual bonds are held to maturity, so coupon and principal payments are predictable. The strategy allows retirees to keep their allocation to these safe but low-yielding bonds at the minimum level needed to cover living expenses, so other portions of their portfolio can be invested more aggressively. The asset-based fee for the Defined Income account is 0.35%. Many do-it-yourself investors aiming to match bond income with future spending needs build ladders of individual bonds with staggered maturity dates. Some new "defined maturity" bond funds, such as Fidelity Municipal Income 2015, 2017, 2019 and 2021, make it easier to build a well-diversified, low-cost ladder (read Build a Bond Ladder With New Funds). Another way to keep core bond holdings simple: Choose a high-quality intermediate-term bond fund, which offers a middle ground between conservative, low-yielding short-term bonds and long-term bonds' generally higher yields and interest-rate sensitivity. (As interest rates rise, bond prices fall.) Harbor Bond Fund (symbol HABDX), which yields 2.4%, comes with the fixed-income expertise of star Pimco manager Bill Gross but, with an expense ratio of 0.53%, it charges small investors lower fees than Gross's behemoth Pimco Total Return. Income investors also should keep an eye on Pimco Total Return's exchange-traded fund sibling (BOND), launched in February. Although the ETF hasn't had time to establish a meaningful track record, it charges 0.55% and it significantly outperformed the mammoth mutual fund in its first few months of operation. Retirees also should consider government-agency bonds. Donald Martin, of Mayflower Capital in Los Altos, Cal., favors Ginnie Maes, which come with U.S. government backing and generally yield more than comparable Treasuries. High-quality funds in this category include Vanguard GNMA (VFIIX, 3% yield) and Fidelity GNMA (FGMNX, 2.7%). Mull the fixed-income fringe. The prolonged period of low rates has prompted even conservative advisers to seek the higher yields that come with riskier bonds. Martin traditionally avoided below-investment-grade debt. But in the last six months, he says, he decided "that was a little too strict." He's now allowing clients to keep a slice of portfolios in emerging-markets debt that's a notch below investment grade. Retirees might consider limited allocations in mutual funds that delve into such holdings but keep a lid on volatility. In the emerging-markets realm, Martin favors funds that stick largely to U.S. dollar-denominated bonds, such as Fidelity New Markets Income (FNMIX). The dollar-based approach shields investors from the significant volatility that can come with currency swings. The fund yields about 5% and has beaten more than 85% of competitors over the past decade. In the high-yield bond category, look for funds that aim to control risk by focusing on less speculative fare. Such funds include T. Rowe Price High-Yield (PRHYX), which yields 7.2%, and Fidelity High Income (SPHIX), yielding 6.5%. Another way to approach the fixed-income fringe: Choose a multi-sector bond fund and let a professional money manager sift through the bond universe for the best opportunities. Loomis Sayles Bond (LSBRX), which yields 5.6%, can dip into high-yield bonds, non-U.S.-dollar government bonds and currencies. Avoid stock 'sucker yields.' Given paltry bond yields, most retirees simply cannot afford to ignore the stock market. High-quality dividend-paying companies can help retirees cover expenses while providing long-term growth potential. Investors' thirst for yield has lately made dividend payers quite popular, driving up prices -- and risks -- of these shares. Dividend payers in the S&P 500 gained an average 5.1% in the 12 months ending in July, versus a 4.1% decline for the non-payers. One key to controlling risk: Money you need within the next five years should not be invested in stocks, advisers and analysts say. Another key to reducing risk is to aim low. Currently, among dividend payers yielding above 4% or so, "you're looking at mostly more expensive stocks," says Josh Peters, editor of the newsletter Morningstar DividendInvestor. Because a falling stock price can cancel out your dividend income, you don't want to overpay. This higher-yielding group includes many of the more traditional stocks that investors think of when hunting for dividends, including regulated utilities, telecommunication companies and real estate investment trusts. Tempting yields of 8% to 10% may actually be "sucker yields," Peters warns. He points to postage-meter maker Pitney Bowes, which has seen its stock price collapse but recently boosted its dividend and yields 10.7% as of August 9. "The market is telling you it's either an incredibly cheap stock on the precipice of a huge turnaround or a dividend that's going to get slashed," the latter being much more likely, he says. In a risky environment for yield hunters, some money managers are aiming to build lower-risk, top-quality dividend portfolios by focusing first on companies' cash flow -- not dividend yield. In the Guinness Atkinson Inflation Managed Dividend Fund (GAINX), launched this year, managers focus on stocks that have delivered cash flow return on investment of at least 10% after inflation in each of the past ten years. The screen "provides some element of downside protection," says co-manager Matthew Page. "The stock price will move around, but we can be certain the underlying business is still very strong and cash generation is good." The process has led the managers to drug maker Pfizer (PFE, 3.6%) and apparel maker VF Corp. (VFC, 1.9%). Such yields may not turn any heads, but a screen for lofty dividends will lead to some distressed companies, "and that's a risky game to be playing in this market environment," Page says. Investors will currently find better value and lower risk in stocks yielding less than 4%, Peters says. His favorites include cereal maker General Mills (GIS, 3.2%), and health care stocks Abbott Laboratories (ABT, 3%) and Johnson & Johnson (JNJ, 3.4%). Retirees who would rather let a professional handle the stock picking can find funds that have proven adept at controlling risk. These include Vanguard Dividend Growth (VDIGX, 2.1%) and T. Rowe Price Equity Income (PRFDX, 2.1%). For investors with a long time horizon -- ten years or more -- master limited partnerships can deliver attractive income. These publicly traded partnerships often focus on the transportation and storage of oil and natural gas. Kinder Morgan Energy Partners (KMP), for example, operates oil and gas pipelines and yields about 6%, and it looks poised to substantially increase distributions in years to come, analysts say. But MLP investors should be prepared to deal with some complexity at tax time, because they'll receive a Schedule K-1 partnership form instead of the 1099 that typically comes with income distributions. And MLPs aren't appropriate holdings for retirement accounts. IRAs or 401(k)s with significant partnership income could get hit with a bill for unrelated business taxable income. Retirees who have spent years building income-focused portfolios say it is still possible to wring enough income from investments to cover living expenses -- it just takes some determination. Michael Hickey, who retired from his marketing business in 2003, says he spends "a lot of hours" researching his investments in dividend-payers such as Procter & Gamble and PepsiCo, corporate bond funds, and other holdings. "I'm too old to go back to work," says the 69-year-old, who divides his time between Swampscott, Mass., and Naples, Fla. "I treat it like it's a job, doing the research." Haven’t yet filed for Social Security? Create a personalized strategy to maximize your lifetime income from Social Security. Order Kiplinger’s Social Security Solutions today.